So much is happening in commercial real estate, it can be difficult to get a clear view of the market. But anytime a $300 billion segment of the market is facing a critical juncture, it becomes time to pull out the binoculars, dust off the lenses and see what’s in store.
That time has come for commercial mortgage-backed securities (CMBS). Coming years will be vital to CMBS loans – and, therefore, to commercial real estate. But with a good look at trends that will shape the market, you’ll be able to stay ahead of the competition.
Over the next two years, CMBS loans will be especially important as the commercial real estate market contains an estimated $300 billion that will need to be refinanced between 2015 and 2017. Several trends impacting the CMBS market will ultimately decide the fate of these loans, including the ones listed here.
Aggressive loan-to-values
Loan-to-Value ratios (LTV) have grown increasingly higher and more aggressive during the last 12 months. From the end of 2013 to the end of 2014, leverage ratios increased by nearly 20 basis points and debt-service-coverage ratio changed from 1.67x to 1.59x, reports show. Smaller originators were more likely to offer higher-leverage ratios than the biggest banks.
Many industry professionals are most concered about these rising LTV ratios, followed by lower debt yields and an increase in interest-only loans. As the competition heats up to make deals, CMBS lenders now offer larger loans that sometimes cover up to 80 percent of the appraised value for multifamily properties.
Uptick in interest-only availability
Interest-only availability has increased compared to previous years. Properties that tick off all the boxes on a CMBS lender’s checklist can get interest-only loans with 75 percent LTV. At lower leverage, perhaps 50 percent to 55 percent, borrowers may be able to swing interest-only for the whole term.
According to Fitch Ratings, there was a 42 percent increase in partial interest-only loans from year-end 2013 to year-end 2014, among deals the firm reviewed. Interest-only loans are also becoming more common, with interest-only terms as long as five years for 10-year, full-leverage loans.
CMBS underwriting has become increasingly aggressive, as evidenced by the rising number of loans that pay only interest for part or all of their terms, and weakening recourse terms.
Springing recourse
Springing recourse has been a hot topic with borrowers, as more restrictions are in place than in 2008. In the following cases, lenders reserve the right to require the borrower to replace the property manager with a third-party property manager acceptable to lender:
– Following an event of default
– If the property fails to achieve certain financial underwriting criteria;
– Upon the property manager becoming insolvent or being in default under the management agreement; and
– If the property is not being managed in accordance with the practices of national management companies managing similar properties in locations comparable to the related property.
Lenders have added teeth to the borrower’s obligation to remove the manager by making the failure to comply with such obligation a nonrecourse carve-out. Many new nonrecourse carve-outs relate to the borrower’s failure to provide property level information necessary to keep the lender fully apprised of the property’s operation and management, or can be viewed as a means to address obstacles previously incurred by lenders in pursing their rights and remedies following default or protecting their security interests.
Borrowers are now subject to expanded financial reporting requirements, including tracking a property’s performance against its forward-looking operating budget, expanded restrictions on a borrower’s ability to manage and operate the property – including the borrower’s ability to deal with tenants and enter into contracts and other agreements necessary for the operation of the property – as well as expanded events of default and nonrecourse carve-outs.
Variable-rate and small-balance programs
CMBS issuance are expected to be in the range of $100 billion to $125 billion in 2015, with the largest volume increase seen in CMBS floaters and the majority of issuance concentrated in fixed-rate conduit.
CMBS lenders are making a push into securitized, small-balance, floating-rate loans, seizing the opportunity to cater to untapped borrowers and bond buyers.
The size of floating-rate loans from CMBS lenders has come down in the past year, which has opened this product up to more borrowers.
The availability of CMBS small-balance programs has increased with multiple companies now offering this product and capping the fees as long as there are not ongoing legal negotiations.
In 2005, there were fewer than a dozen lenders active in the CMBS market; today there are 40 lenders, large and small. This had led to an increase in availability of CMBS small-balance programs.
Tertiary markets
There has been an uptick in CMBS availability in tertiary markets. CMBS loans are even being used to finance projects in rural areas that most banks and life insurance companies avoid.
The percent of CMBS loans secured by properties outside of the top 25 metro areas has increased from 35 percent before the global financial crisis to nearly 50 percent as of third-quarter 2014. For issuance to increase to more than $100 billion in coming years, CMBS originators would need to have about 30 percent market share, driven primarily by tertiary markets.
The CMBS market has only surpassed the $100 billion annual issuance level three times: in 2005, 2006 and 2007. Because of the record volume in those years, an unusually heavy supply of debt maturities will hit in the coming three years, which may lead to a shortfall if demand among investors proves insufficient to handle the volume.
Interest rates for CMBS loans continue to be roughly 15 basis points higher than the leading competition for comparable properties – usually provided by Fannie Mae or Freddie Mac lenders, experts say. As a result, most CMBS loans are being made in secondary or tertiary markets to Class B or lower multifamily properties.
By keeping up with these trends, commercial mortgage brokers can stay ahead of the curve when it comes to CMBS loans, and the hundreds of billions of dollars of refinancing that will take place in coming years.
